For a variety of reasons, we often run across clients who decide to retire “early”. In the eyes of the IRS, early retirement is defined as any time before the age of 59 ½. Taking a withdrawal from an IRA account prior to reaching 59 ½ will typically trigger a 10% penalty on top of the normal taxes. So what are your options for income if you retire early? The following are examples of how you can avoid paying penalties while collecting an income from your investments.
1) Living Off Non-Retirement Assets
If you are fortunate enough to have built a post-tax nest egg of cash or investment assets, you will not be subject to penalties, and will only pay tax on the gains you have realized. We will often recommend these assets be the first a new retiree should tap into, allowing pre-tax assets in IRAs and 401(k)’s to continue to grow tax-deferred. Of course you need to keep in mind that having a certain amount of cash on hand is always a good idea, so don’t deplete checking and savings accounts completely.
2) The Age 55 Rule
Often overlooked, the age 55 rule is a powerful tool available to those retiring the calendar year they turn 55 or greater, but have not yet reached 59 ½. This rule is specific to 401(k) or 403(b) plans, and does NOT apply to IRA accounts. Simply put, you can take out as much or as little income as you would like from your company plan as long as you retired or left your company in the year you turned 55 or greater, and you will not be subject to the 10% penalty on withdrawals. For this reason, you will want to either leave your account in your employer sponsored plan, or only rollover a portion to an IRA, leaving enough in the 401(k)/403(b) to take income until age 59 ½. It is important to note you MUST have turned at least 55 in the year you leave your employer, you cannot leave at an earlier age and then later start penalty-free withdrawals at 55.
3) Roth IRA Basis
People often forget they have access to Roth IRA contributions at any age, regardless of if they have retired or not. You will only pay penalty and tax if the earnings (growth) are withdrawn early from Roth accounts. However, this is not normally a recommended method since Roth accounts are one of the few investment accounts that grow tax-free; nonetheless it remains an option if you have no other alternatives. For the most part, we would advise people to allow Roth accounts to grow tax-free for as long as possible.
4) Substantially Equal Periodic Payments (Rule 72t)
Another method used to withdrawal income at any age is Rule 72(t), but it is only recommended for those with substantial retirement savings. Rule 72(t) allows an individual to start taking an income stream from a retirement account at any age without penalty, but you must continue that income stream for 5 years or until turning 59 ½, whichever is longer. If for example you start taking an income at age 58, you must take the same income until you reach age 63, at which time you can decide how you would like that adjusted if at all. If you start your income at age 52, you must take the same income until you are 59 ½. There are several IRS-approved methods of calculating how much income you may receive, depending on your age, account balance, and the federal mid-term interest rate at that time. These payments can be applied to a single IRA or multiple IRA accounts at the same time.
5) Exceptions to the Early Withdrawal Penalty
There are a few other ways to access retirement funds early and still avoid paying the 10% penalty. If the following situations apply, you may be able to avoid paying penalties:
- You become totally and permanently disabled.
- You use the money for qualified higher education.
- You use the money to purchase your first home (maximum $10,000).
- You use the money to pay for medical expenses in excess of 10% of your adjusted gross income.
- You use the money to pay for your health insurance premiums while unemployed.
Before utilizing any of the above methods, it’s important to make sure it fits within your comprehensive financial plan. Please consult a financial professional for nuances that may apply to your particular situation.
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This document is for educational and informational purposes only and does not constitute an advertisement or solicitation of any securities or investment services provided Mainstay Capital Management, LLC (“MCM”). This document should not be construed as investment, tax, or legal advice, or a solicitation, or a recommendation to engage in any specific strategy. MCM is an independent investment adviser registered with U.S. Securities and Exchange Commission. MCM specializes in workplace savings plan portfolio management and retirement planning advice for active employees and retirees. This document was prepared by MCM primarily based on data collected and analyzed by MCM. The opinions expressed herein are those of MCM alone and are for background purposes only. MCM does not purport the analysis to be full or complete or to constitute investment advice and should not be relied on. In addition, certain information contained herein or utilized to draw the conclusions contained herein has been provided by, or obtained from, third party sources. While MCM believes that such sources are reliable, it cannot guarantee the accuracy of any such information and does not represent that such information is accurate or complete. All materials and information are provided “as is” without any express or implied warranties by MCM. MCM charges its fee based on a percentage of assets under management, which creates an incentive and conflict of interest to increase assets in that account. Furthermore, MCM has two different fee schedules, and therefore has a conflict of interest when assets or accounts move from the lower fee schedule to the higher fee schedule. Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance. Consult your financial professional before making any investment decision. Please see MCM’s Form ADV Part 2A and Form CRS for additional information.